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Pat MurphyWritten by economists Charles Goodhart and Manoj Pradhan, The Great Demographic Reversal is a provocative read. And with 81 diagrams and 23 tables, it’s chockful of data in support of its thesis.

That thesis is simple: “Of one thing we are sure, the future will be nothing like the past.” Or at least nothing like the recent past.

The authors argue that the three decades beginning in 1990 were a demographic sweet spot. Thanks to a vast expansion of the labour supply available to pump goods into the world’s trading system, the range of affordable consumer purchases significantly increased and inflation remained relatively constrained.

The biggest drivers came from political change.

China dumped Mao Zedong’s socioeconomic dogma and joined the modern trading system, while the collapse of communism reintegrated Eastern Europe into that same system.

In the meantime, free trade became the West’s dominant orthodoxy, which meant that markets were relatively open to the products of these new players.

The consequences were highly disruptive, not only in terms of the impact on established market participants but also with respect to what we thought we knew about how the economy worked.

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Classically, inflation has been defined as “too much money chasing too few goods.” If the amount of money circulating in the economy grows faster than the amount of goods and services being produced, there’ll be upward pressure on prices.

Central banks come into play here. So, for background, let’s briefly digress.

The financial term “quantitative easing” is a euphemism for what used to be called “printing money.” And “printing money” is itself a figure of speech. Where once upon a time it referred to printing physical notes and minting coins, now money creation is overwhelmingly a digital phenomenon. But it’s still liquidity that’s injected into the system and thus available to buy goods and services.

For various reasons, some of them estimable, central banks have done a lot of this injecting for quite a while now. However, the inflationary dog didn’t bark. Although money creation was outrunning the growth of the domestic economy, inflation stayed relatively low. It was as if the old rules had been rendered obsolete.

The Goodhart-Pradhan thesis offers at least a partial explanation.

While the productive capacity of domestic Western economies only grew modestly, huge supplies were pouring into the trading system via the entry of the new players referred to above. Consequently, there were a lot more goods for the newly created money to chase.

That, though, is about to change. The sweet spot is “turning sour.”

Declining birth rates “will bring about a sharp reduction in the growth of the labour force in many countries.” China, the source of much of the hitherto increased labour supply, will be hit particularly hard. The draconian “one child” policy – that once struck some progressive observers as enlightened – will exact its price.

Simultaneously, the aging of the population in most Western societies will put pressure on dependency ratios, defined as the number of active workers available to generate the goods and services consumed by those no longer in the workforce. And it isn’t just a question of people living longer in retirement. There’s also the extent of care that’ll be required as the numbers suffering from incapacitating dementia grow. Older people who can live independently are less of a social burden.

Still, not everything is necessarily ominous. There’s the matter of inequality.

As Goodhart and Pradhan put it, “inequality within economies has risen to critical levels, even though inequality across nations has actually fallen thanks to the rise of China and Asia.” The causes of this internal inequality may be complicated, but the impact on the effective labour supply played a part.

If you worked in an industry suddenly facing competition from new lower-cost providers, your bargaining power was correspondingly reduced. And it didn’t really matter what form that competition took. It could be goods arriving from abroad to undersell domestic output, or it could be existing jobs directly transferred offshore. The effect was the same.

But if the Goodhart-Pradhan analysis is correct, the future will be materially different from what we’ve experienced over the last 30 years.

Because labour will be scarcer, bargaining power will shift and income inequality will be reduced. Inflation, however, will trend higher and social expectations around things like retirement age will need revisiting.

Interesting times ahead!

Pat Murphy casts a history buff’s eye at the goings-on in our world. Never cynical – well, perhaps a little bit.

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